The need of individuals, businesses, government agencies and other entities to transfer risk from time to time is well known. Many financial instruments transfer financial risk, each in its own way. Insurance is a particular class of financial instruments in which risks are defined by contract and explicitly transferred from one party (the insured) to another (the insurer). Reinsurance is a particular class of financial instruments in which risks are defined by contract and explicitly transferred from an insurer to another party (the reinsurer). By general and common interpretation, these descriptions of insurers and reinsurers encompass all entities who undertake to assume risk with the expectation of gain or service, including without limit risk pools, associations, and guarantee funds, for example. In general, risk transfer contracts are entered into because the contract improves the financial position of both parties as each party balances risk and return.
The risks of loss of life, health, property, income and other value are generally, although not always, transferred to the capital markets by means of investments in insurers and reinsurers. The insurers and reinsurers aggregate the risks they underwrite. The risk-return profile of an insurer's portfolio of risks is different from the risk-return profile of any one of the risks. Insurers and reinsurers manage the risk and return of their portfolios of liabilities in the context of their portfolios of assets and the expectations of their investors. Investors, therefore, are interested in the portfolios of risks underwritten by the insurers and reinsurers in whom they invest. Because the insurers and reinsurers have portfolios of assets as well as portfolios of liabilities, the investors are interested in the combined asset and liability portfolio of insurers and reinsurers.
Current requirements for financial reporting do not, however, provide for complete and timely information about the portfolios of assets and liabilities held by insurers and reinsurers. Until the invention, investors are not able to invest in insurers or reinsurers about which they have complete information about the portfolios of assets and liabilities. As a result, until the invention, capital does not flow promptly to the insurers and reinsurers in response to changes in events. Also as a result, insurers and reinsurers must use simple signals to the capital markets, such as adding exclusions to insurance policies in the wake of events.
The risks of catastrophic loss of property have grown as homes and businesses have increasingly become concentrated and have increasingly been built on the major coastal areas of the United States and other countries. In the Pacific Rim, such coastal areas present the hazards of earthquake and tsunami as well as the hazards of windstorm and flooding. Although various responses have been developed in the 1990's, such as the California Earthquake Authority, the Florida Windstorm Association and the creation of new financial tools including Catastrophe Bonds, Contingent Surplus Notes, Exchange-Traded Catastrophe Options and Catastrophe Equity Puts, these are deemed to be incomplete solutions by their supporters as well as their critics.
Capital does not flow readily from capital markets to those insurers or reinsurers who have experienced unanticipated risk events that led to financial loss because it is difficult for the investor to know if a financial loss recorded by an insurer or reinsurer is due to the realization of insured contingencies or bad management. One of the principal functions of management is to manage underwriting leverage, which is the extent to which capital is committed or possibly over-committed to the underwriting of risks. The underwriting portfolios of insurers and reinsurers are not visible to investors today; all that is available is aggregate statistics such as the dollars of premium income realized from contracts underwritten in a period and the company's estimate of total future payments for each major class of insurance. There has been no direct way for an investor to distinguish a financial loss reasonably expected to arise from an event such as a windstorm, from a financial loss arising from an undesirable concentration of exposures in any one kind of risk such as residential property.
Evidence for the lack of capital flow is that markets for insurance contracts often do not clear. Prices do not change to reflect all changes in information. Sometimes consumers are unable to find policies at any price. Sometimes insurance companies are unable to find reinsurance policies at any price. The reason cited is that the insurance industry (or the reinsurance industry) does not have the financial capacity to underwrite the risks.
In addition to the problems arising from the lack of transparency of portfolios of assets and liabilities, problems arise because insurance contracts bundle suretyship, risk transfer and claim handling together in the context of product design and pricing. This itself is not a problem for the insured, but it creates a problem for the investor which wishes to participate in the risk transfer alone, in the following four ways and others.
First, entities desire to make more efficient use of their capital. More than 3,000 life, health and property-casualty insurance companies operate in the United States today. There is duplication of effort and inefficiency in this system. During the 1990's new companies were set up to deal with specific problems, in spite of the high cost of doing so, because it had been difficult for companies to demonstrate effectiveness in one service area, such as claim administration, with performance measures that reflect the consolidated effect of results in all three service areas (risk transfer, claim administration, and suretyship). In the 1990's, commissions for reinsurance policies have typically been from 3% to 20% of the premium paid for the policy; there are additional expenses for both the insurer and the reinsurer. Also, it has been difficult for reinsurance companies to allocate their underwriting capacity efficiently because no trading floor exists for the exchange of reinsurance contracts. Even conceptually such a floor cannot exist for today's reinsurance contracts because such contracts combine two services, suretyship and risk transfer. Suretyship is the assurance that the contract will be performed.
Second, new technologies create advantages for alert entities and their customers or stakeholders. Until the present invention, insurers and reinsurers have been slow to implement new technologies because of regulatory hurdles and the fact that insurance contracts combine risk transfer, suretyship, and claim administration, each of which is amenable to technology not suitable for the other. Although there are firms that manage claims and do not sell insurance, most insurance claims are managed by the insurance companies that sell the insurance. Investors have no way to distinguish the performance of a claims management organization that is embedded in an insurance company and reward good claim management with access to capital. Investors have no way to distinguish the performance of an underwriting unit (obtaining adequate price for risks underwritten) that is embedded in an insurance company, and to reward good underwriting with access to capital. Therefore it is difficult for either the claims function or the underwriting function to access the capital needed to finance the development of new technology.
Third, consumers and citizens demand increasingly diverse products and services from the businesses and agencies that serve them. Consumers, citizens and businesses demand increasingly broad coverage from their insurance companies. Until the invention, the insurance industry has typically taken several years to respond to new demands. One reason for the lack of timely response is that the insurance policy changes have required coordination of risk transfer, suretyship, and claim administration. There has been no process in place to deal with each of these areas on its own.
Fourth, although electronic auctions have become a part of the general economy, electronic auctions have not become a significant part of the risk-transfer process. One reason might be that the risk contracts being offered are not defined with sufficient precision or standardization.
In addition to the foregoing, several examples of traditional financial risk management programs are described below.    Exchange Traded Futures and Options—The vast majority of futures and options traded on organized exchanges are based on one of the following: stock price, bond price, metal price, energy price, agricultural commodity price, exchange rate, stock index value, or bond index value. In the vast majority of cases, the underlyer can be purchased in the open market. However, there are several exceptions on the current futures markets.    Catastrophe Futures—Property casualty catastrophe futures and options are traded on the Chicago Board of Trade. These are based on indexes of insured catastrophe losses occurring in the United States. Catastrophe futures are based on a liability index, rather than an actual liability of one or more individual insurance policies.    Index Futures—The Bankruptcy Index is now traded on the Chicago Mercantile Exchange. This contract is based on an index of the number of consumer bankruptcy filings. Bankruptcy Index futures and options are based on an index which correlates with a liability: bankruptcy and dollars of consumer credit bad debt.Heating Degree Day contracts are also traded on the Chicago Mercantile Exchange for several cities. These contracts correlate with energy demand and energy prices. These have no underlying asset or liability.Presently, there are no known exchange-traded futures based on baskets of insurance policies. See, Commodity Futures Trading Commission, “Futures and Options Contracts Designated by the Commodity Futures Trading Commission as of Sep. 30, 1998”, http://www.cftc.gov/annualreport98/contractsdesig.htm.    Detachable Securities—Detachable securities have occurred in a variety of forms over the years. Fairly common versions of detachable securities include: put options on bonds, call options on bonds, convertible debt warrants, detachable stock warrants, and detachable bond coupons. To date, there is no known case of the detachable security being a listed security which is exchange traded, but not related to debt or equity of the issuer. For example, there are no known detachable securities for exchange-traded gold futures, wheat futures, or heating degree day options.    English Auction—The most common form of auction is an English auction, where all bidders gather at the same time in the same place to bid on one or more assets, and the auctioneer solicits progressively higher bids from the potential buyers until only one bidder is left. The winner claims the item, at the price he last bid.    Dutch Auctions—In a Dutch auction for a single item, bidders can see the current price of one asset and must decide if they wish to purchase at that price or wait until it drops. The winner is the first bidder at the current price. To date, versions of Dutch auctions have been used for auctioning multiple identical assets. One version of a Dutch auction is used for IPOs to allow all bidders to bid for a particular number of shares at a particular price. The sellers take the highest group of bids which will sell the number of shares in the IPO. All successful bidders get their shares at an identical price: the lowest successful bid. An example of this process was the WR Hambrecht and Co. underwriting for the Andover.Net IPO in 1999.    Other Index Futures and Options—The vast majority of futures and options traded on organized exchanges are based on one of the following: stock price, bond price, metal price, energy price, agricultural commodity price, exchange rate, stock index value, or bond index value. In the vast majority of cases, the underlyer can be purchased in the open market. However, there are several exceptions on the futures markets. Catastrophe futures and heating degree day futures were mentioned above.The Bankruptcy Index is now traded on the Chicago Mercantile Exchange. This contract is based on an index of the number of consumer bankruptcy filings. Bankruptcy Index futures and options are based on an index which correlates with a liability: bankruptcy and dollars of consumer credit bad debt.